From "Prepare for a hard landing"
by Stephen Roach, Financial Times, November 23, 2000

The writer is chief economist at Morgan Stanley Dean Witter

The risks of a hard landing, or an outright recession, are high and rising - especially in the US. I would assign a 40 per cent probability to such an outcome in the first half of next year. For me, that is tantamount to maximum alert.

The case for a hard landing rests on the combined impact of two sets of macroeconomic forces - a natural deceleration in the global economy and the possibility of a destabilising shock.

First, there are the lagged effects of 1.75 percentage points points of monetary tightening by the US Federal Reserve and 2.25 percentage points of tightening by the European Central Bank, in the past 17 months. Most of those impacts are still in the pipeline.

Second, there is the sharp recent rise in energy prices, which acts as a tax on the energy-consuming industrial world. Third, the recent widening of credit spreads in the US and Europe will undoubtedly take a toll on business spending, especially in the technology-intensive telecommunications sector.

Fourth, there is new vulnerability in the developing world, especially in Asia where structural reforms have been lagging. A downturn in the global technology cycle could wreak havoc on these export-dependent economies.

Fifth, there is the impact of a negative wealth effect in the US: after five years of 25 per cent gains, the stock market will probably be down this year. That should give savings-deficient US consumers considerable pause for thought.

The problem arises in the transition from this year's vigour to next year's slowdown. These transitions are typically uneven and often quite precarious. They normally entail a few quarters of below-trend growth, as inventories and production are reconfigured in a climate of softer demand. During that transition, the world economy often slows to its "stall speed" - a sluggish growth rate that could easily give way to recession, should an external shock occur.

That brings the second set of macro forces into play: the impact of the shock. Rapidly growing economies have ample cyclical immunities to withstand shocks. Economies inching ahead at their stall speed do not. The soft-landing call for 2001, therefore, rests on our ability to anticipate the next shock.

Three possibilities are most worrisome, the first being a full-blown energy shock arising from war in the Middle East or a market-driven spike in prices of refined petroleum products or natural gas.

The second possibility is an earnings shock in the US. Profit margins could be squeezed by energy costs, corporate financing costs, labour costs and technology costs. As volume growth slowed, earnings could tumble, which would drag the US stock market down farther. Then the dreaded negative wealth effect could bite - prompting wealth-dependent US consumers to replenish long-depleted saving balances.

Finally, there is the possibility of a dollar shock. The armour-plated greenback has been vital to America's virtuous circle. Yet the dollar is a disaster waiting to happen. America's record external deficit is only part of the problem. A downturn in the global cycle of mergers and acquisitions threatens to crimp capital inflows into the US.

A narrowing of the growth differential between the US and the rest of the world could challenge the notion that investors are willing to attach a permanent premium to dollar-denominated assets. And the recent political neutering of US leadership could be a problem too. If the dollar goes, America's virtuous circle could turn vicious very quickly. Europe and Japan could then be struggling with stronger currencies.

By our reckoning, real GDP growth in the US could slow to the 2-2.5 per cent range in the first half of next year, mimicking the stall speed that presaged the hard landing a decade ago.

Stall speed combined with shocks is the recipe for a classic hard landing. If the US - long the engine of the global economy - sneezes, the rest of an increasingly integrated world will quickly catch the same cold.

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